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Pegged to Hedge Against Volatility: The Story of Stablecoins and How They Reshaped the Crypto Industry

CryptoStake explains how stablecoins became the backbone of crypto exchanges

Stablecoins have become the lifeblood of crypto exchanges and a reliable hedge against the infamous market volatility. Look at Tether's market cap - up to 100 billion USD in just seven years! Same story with USD Coin (30 billion USD in four years). It is a truly remarkable feat that deserves an in-depth exploration and detailed explanation. Stablecoins represent a whole new asset class, bringing stability to the once-unpredictable world of crypto. Since the launch of the first one (BitUSD in 2014), stablecoins have seen incredible growth, teaching us valuable lessons about digital currency stability.

The genesis of stablecoins: BitUSD

The creation of BitUSD in 2014 marked the dawn of stablecoins. Envisioned by Dan Larimer and Charles Hoskinson, later known for their work with EOS and Cardano, respectively, BitUSD introduced the market to a crypto-backed stablecoin issued on the BitShares blockchain. 

Despite its pioneering role, BitUSD faced challenges maintaining its peg to the US dollar, a struggle highlighted in BitMEX’s detailed analysis. The stablecoin's reliance on BitShares as collateral—volatile and unbacked—proved a critical vulnerability. When BitShares' value fell, BitUSD could theoretically be used for arbitrage, buying more BitShares at a lower price. 

However, the absence of a reliable reserve meant BitUSD behaved more like a volatile security than a stable currency. By 2018, BitUSD had lost its 1:1 parity with the US dollar, unable to recover, yet its existence set the stage for the development of pegged stablecoins, demonstrating both potential and pitfalls.

Learning from NuBits: diversification and stability

2014 also saw the arrival of NuBits, a second attempt at crafting a stable digital currency, this time backed by Bitcoin. Despite the innovative approach, NuBits faced insurmountable challenges. Bitcoin's notorious volatility rendered the reserves inadequate to maintain NuBits' peg in turbulent market conditions. This situation underscored a fundamental investment principle: the critical need for diversification. 

NuBits' reserves were not only volatile but also insufficiently diversified, leading to its decline. Trading now at approximately 0.004 USD, NuBits serves as a cautionary tale within the crypto community. The failure highlighted the peril of relying on a single volatile asset to back a stablecoin. It stressed the importance of having a robust, diversified reserve as a buffer against market volatility, a lesson that would shape the development of future stablecoins aiming for enduring stability in the ever-fluctuating cryptocurrency market.

TerraUSD's algorithmic challenge

TerraUSD (UST), launched as an algorithmic stablecoin, faced a dramatic downturn in May 2022, illustrating the vulnerabilities of relying solely on algorithmic mechanisms for stability. UST's design intended to maintain a 1:1 value with the US dollar through arbitrage and supply adjustments controlled by its centralized authority. 

However, this approach faltered when demand waned, revealing a significant weakness: the reliance on market forces and incentives was insufficient to guarantee stability. Despite the Luna Foundation Guard amassing over 70 thousand bitcoins to back UST, the stablecoin could not withstand a market crash, plummeting to around 0.02 USD. TerraUSD's failure starkly demonstrates the limits of algorithmic stablecoins in the absence of a fully backed reserve, serving as a critical learning moment in the quest for a truly stable digital currency.

Tether: setting the standard in stability

Tether (USDT), introduced in 2014, has emerged as a paragon of stablecoin success, achieving a remarkable market capitalization of over 100 billion USD. Unlike its predecessors, Tether sidestepped the pitfalls of crypto-collateralization and algorithmic models by anchoring its value directly to hard fiat reserves. For every USDT issued, an equivalent US dollar is held in reserve, ensuring its stability even in theoretical market crashes. 

This 1:1 fiat-backed approach has not only provided a reliable medium of exchange within the digital asset space but also garnered cautious regulatory recognition. Tether's resilience and operational model have set a new benchmark for stablecoin reliability, demonstrating that a robust, transparent backing in traditional currency can sustain stability in the volatile world of cryptocurrencies. As such, Tether continues to dominate the stablecoin market, offering a secure anchor amidst the tumultuous seas of digital finance.

Dai: decentralization meets stability

Launched in 2017 by MakerDAO, Dai has become a beacon of stability in the decentralized finance (DeFi) sector. Distinctly, Dai combines the best of both worlds: it is a decentralized, crypto-backed stablecoin with a layer of algorithmic governance. Unlike purely algorithmic stablecoins, Dai maintains its peg to the US dollar through a mix of crypto collateral and smart contract algorithms. 

For each Dai, 1.70 USD worth of Ethereum must be locked up, creating a buffer that safeguards against volatility. This mechanism, coupled with diversified reserves including USD Coin and Wrapped Bitcoin, provides a multifaceted defense against market instability.

Approximately half of Dai's reserves are in fiat-backed stablecoins, adding an extra layer of security. Dai’s innovative approach showcases how blending crypto-backing with careful algorithmic management can offer a durable solution to the challenges of stablecoin stability, securing its place in the hearts of DeFi enthusiasts.

Closing thoughts

The journey of stablecoins from BitUSD's pioneering attempt to Dai's innovative solution encapsulates a remarkable evolution in digital finance. Each stablecoin's story, whether marked by triumph or setback, contributes to a broader understanding of what it takes to achieve stability in the volatile cryptocurrency market. The failures of BitUSD, NuBits, and TerraUSD underscore the vital importance of solid backing and the dangers of overreliance on volatile assets or algorithmic promises. 

In contrast, Tether and Dai exemplify the potential for stability through fiat collateralization and a hybrid of crypto-backed and algorithmic mechanisms, respectively. As we look to the future, the lessons learned from each of these endeavors will undoubtedly shape the development of new stablecoins.